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Wednesday, April 20, 2011

US debt row masks deeper woes

Apr 20, 2011

By Ezra Klein

UNITED States Treasury Secretary Timothy Geithner does not want the market to smell his fear. 'I want to make one thing perfectly clear,' he said on Sunday. 'Congress will raise the debt ceiling.' But if there was truly so little doubt, Mr Geithner wouldn't have been peppered with questions about it on the Sunday shows.

Raising the debt ceiling may be economically necessary but it's politically lethal. Only 16 per cent of Americans want the debt ceiling raised, according to an NBC/Wall Street Journal poll. Senator Marco Rubio said he wouldn't vote for an increase unless it included 'a plan for fundamental tax reform, an overhaul of our regulatory structure, a cut to discretionary spending, a balanced-budget amendment, and reforms to save Social Security, Medicare and Medicaid' - everything on the conservative agenda, basically.

And this is where things get dangerous. Republicans and Democrats both bear substantial blame for the country's rising deficits. The Bush tax cuts and the Medicare Prescription Drug Benefit and America's various wars - none of which have been paid for, and all of which are ongoing - are major contributors to the mounting debt, and all were passed by Republican majorities. The debt ceiling had to be raised seven times during the George W. Bush years, and the policies that helped drive those increases - not to mention the financial crisis that followed them - have not been undone under President Barack Obama.

But the Republicans want to pin the debt on the Democrats, and they want major concessions in return for their vote. Democrats, however, aren't going to agree to the Republican plan to deny partial responsibility for the country's debt and hold the country's credit rating hostage in order to reshape the government along more conservative lines. Fear over exactly this sort of political gridlock is what led Standard & Poor's to downgrade the nation's credit outlook to 'negative' on Monday.

To understand the danger posed by the debt ceiling, it helps to understand the financial crisis. A lot of banks and investors held assets based on mortgages they thought were safe. They weren't. That meant that no one knew how much money they really had, or how much money anyone else really had. So the market did what woodland creatures do when they get confused and scared: It froze. And so too did the economy. As the unemployment rate shows, the economy still has not completely thawed out.

If Congress fails to lift the debt ceiling beyond its current limit of US$14.29 trillion (S$17.8 trillion) - or even waits too long - the chain of events will be similar, but the asset under question will be America itself, not some newfangled Frankenstein bond made out of mortgages. Which means the aftermath would be much, much worse.

'The cornerstone of the global financial system is that the United States will make good on its debt payments,' said Mr Mark Zandi, chief economist at Moody's Analytics. 'If we don't, we've just knocked out the cornerstone and the system will collapse into turmoil.'

Throughout the financial crisis, America's great advantage was its status as the single safest investment in the world. That makes it easier for it to borrow money to ease a downturn. It makes it easier for its central bank to buy bonds to keep interest rates low. It gives it tools and flexibility that, say, Greece simply doesn't have. But all of that is based on the market's perception that America's debt is, indeed, a safe investment, that the US government will pay it back, that it won't inflate its way out of the fiscal holes it digs, that the political system will make tough decisions when necessary.

Confidence, once lost, is hard to regain. 'It's like a cat which jumps on a hot stove,' said Mr Bill Gross, co-founder of Pimco. 'Burn it once, and it doesn't jump back on there.'

Mr Gross, incidentally, not only thinks the stove is getting pretty hot; his firm is also turning up the heat: Pimco is now betting against Treasuries. If he's right, however, and the various foreign and domestic investors buying and holding Treasuries end up getting less than they were expecting, or undergo a lot of strain and anxiety while Congress dithers, they'll probably start putting their money elsewhere.

At that point, the 'then what' looks pretty scary. Balancing America's long- term budget won't be easy. But it'll be much harder if rising interest rates become a noose on the recovery. 'Once the interest rate starts to rise, the ballooning of the interest-carry cost on this debt will scare the bejesus out of the system, and it'll be a feedback loop into the market,' said Mr David Stockman, who served as former president Ronald Reagan's budget director.

In other words, the more the market worries about America's ability to repay its debt, the harder that debt becomes to pay back. High interest rates slow economic growth and increase the amount it has to pay to borrow, both of which mean its debt will grow as a percentage of the economy.

Which gets to the essential irony of this whole conversation: By taking the debt ceiling hostage in a bid to address the deficit, Congress could provoke the exact calamity it's seeking to prevent. What Americans worry about when they worry about the deficit is that the market will lose confidence in the country's ability to pay back its debts and begin charging more to buy Treasuries. There's no quicker way to undercut the market's confidence in the US government than for it to walk up to the abyss of default.

The likeliest disaster here will not be caused by Congress refusing to raise the debt ceiling. And, as Mr Geithner says, Congress will raise the debt ceiling. Eventually. But there'll be a lot of partisan posturing between now and then.

In 2006, then-Senator Barack Obama lodged a protest vote against an increase in the debt ceiling - a vote he's since called 'a mistake'. The US economy, however, is weaker than it was then, the deficits are more worrying and the markets are more fragile. So the normal Congressional bickering could prove especially dangerous.

Earlier this month, Congress waited until the last possible minute to avert a shutdown - waited so long, in fact, that the government was technically unfunded for a few moments - and we could see it wait till the last minute on the debt ceiling. But the last minute may be too late.

'The risk is not that we get to July and run out of desperation measures,' said Citigroup's Mr Peter Orszag, who previously served as Mr Obama's budget director. 'Both political parties realise that would be crazy. But the worry is you're in June, and you think you have time, and the market blows apart early.'

In the end, the debt ceiling is not just about the debt ceiling. It's about America's capacity to solve its economic problems. If the two parties can come to a grand bargain on debt and deficits by the end of next month, then great. But if they can't - and that's where the smart money is - the debt ceiling is not the moment to demonstrate to the markets that Washington is broken.

Once the pin on that grenade is pulled, there's no putting it back in.